Federal Reserve and Monetary Policy

Formal Structure of the Fed THE FEDERAL RESERVE (FED)

Federal Reserve Districts

Central Bank Independence Factors making Fed independent 1.Members of Board have long terms 2.Fed is financially independent: This is most important Factors making Fed dependent 1.Congress can amend Fed legislation 2. President appoints Chairmen and Board members and can influence legislation Should Fed be Independent? Case For: 1.Independent Fed likely has longer-run objectives, politicians don't: evidence is better policy outcomes 2.Avoids political business cycle 3.Less likely deficits will be inflationary Case Against: 1.Fed may not be accountable 2.Hinders coordination of monetary and fiscal policy 3.Fed has often performed badly Overall: Fed is quite independent

The Market for Reserves and the Fed Funds Rate Demand Curve for Reserves Demand Curve for Reserves 1. R = RR + ER 2. i ↓opportunity cost of ER↓, ER ↑ 3. Demand curve slopes down Supply Curve for Reserves Supply Curve for Reserves 1. i ↑, discount loans ↑, quantity of Reserves supplied ↑ 2. Supply curve slopes up Market Equilibrium Market Equilibrium R d = R s at i * ff

Supply and Demand for Reserves

Response to Open Market Purchase or Lowering of Discount Rate

Response to Rise in Reserve Requirements

Goals of Monetary Policy Goals Goals 1.High Employment 2.Economic Growth 3.Price Stability 4.Interest Rate Stability 5.Financial Market Stability 6.Foreign Exchange Market Stability Goals often in conflict

Taylor Rule Taylor Rule Fed funds rate =inflation + equilibrium real fed funds rate + 1/2 (inflation gap) + 1/2 (output gap) Phillips Curve Theory Phillips Curve Theory Change in inflation influenced by output relative to potential, and other factors Change in inflation influenced by output relative to potential, and other factors When unemployment rate < NAIRU, inflation rises When unemployment rate < NAIRU, inflation rises NAIRU thought to be 6%, but inflation falls with unemployment rate below 5% NAIRU thought to be 6%, but inflation falls with unemployment rate below 5% Phillips curve theory highly controversial Phillips curve theory highly controversial Taylor Rule, NAIRU and the Phillips Curve

Taylor Rule and Fed Funds Rate